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Thursday, September 27, 2007

I want today to give you a crash course on the strengths and weaknesses of economics, with special reference to the labour market. It occurs to me that, because of the specialised nature of your work, most of you probably already know a fair about the topic. If so, I hope you’ll find what I say reinforcing rather than boring. Let me start by saying that I don’t see myself as an economist, but rather as a journalist who writes about economics. This allows me to act as a kind of interpreter and go-between, standing between the economists and the public. I see my role as providing my readers with a critique of economics and economists, much as our theatre critics provide our readers with a critique of the latest plays. My goal is to explain and demystify economics, advising my readers on when they ought to accept the advice of economists and when they shouldn’t.

The subject matter of economics

Economics is the study of how market economies organise the production and consumption of goods and services. In other words, it deals with a very important aspect of life - all of us are consumers and most of us are producers - but only one aspect. It’s preoccupied with the practical, material aspect of life, so that if you get too preoccupied by economics - as many business people, politicians, economists and economic rationalists do - you risk neglecting or devaluing the non-material aspects of life, such as the social, the artistic and the spiritual.

Macro-economics is concerned with seeking to manage or guide the overall, national economy as it moves through the ups and downs of the business cycle. The managers of the economy use various instruments to stabilise demand, holding it back when the economy is growing strongly and threatening to worsen inflation, but boosting demand when the economy’s growth is weak and unemployment is high or rising. The object of demand management is simply to reduce the amplitude of the cycle, pulling down the peaks and filling in the troughs, thereby keeping both inflation and unemployment low. Historically, the main instrument used to manage demand was the budget (known as fiscal policy). But for the past 20 years or so the dominant instrument has been the manipulation of interest rates by the now-independent Reserve Bank (known as monetary policy). The Reserve raises interest rates when it wants to discourage borrowing and spending and thus inhibit inflation pressure; it lowers rates when it wants to encourage borrowing and spending and thus hasten growth and job creation.

A primer on microeconomics

But that’s as much as I want to say about macro. Micro-economics is trickier, more interesting, more germane to our purpose and more controversial. Micro is the study of individual consumers, workers and firms using markets to produce and consume goods and services. At the heart of microeconomics is what’s called the ‘neo-classical model’ in which price is set by the interaction - and intersection - of demand on the one side and supply on the other. So conventional microeconomics is preoccupied with price; it strips away other commercial considerations so it can get to what economists regard as the heart of the matter, price. If economists wore tee-shirts, what they’d say is: Prices Make The World Go Round.

It’s the ‘price mechanism’ that economists see as bringing supply and demand - and hence markets - into equilibrium, or balance. Movements in relative prices - that is, the price of one good relative to other goods - are seen as conveying ‘signals’ to both buyers and sellers, consumers and producers. A rise in price says to producers, produce more - it’s now more profitable to be selling these things, so get cracking and make more of them. A rise in price says to consumers, buy less - look for cheaper substitutes or be more economical in your use of this stuff. Now, if a rise in price calls forth an increase in supply on the one hand, but a decrease in demand on the other, what happens? The price falls back and supply and demand settle at a new equilibrium point. Similarly, a fall in relative prices will send the opposite signals to buyers and sellers, calling forth a reduction in supply and an increase in demand which raises the price and establishes a new equilibrium. Here you see the rationale for the cry of laissez faire - the market is assumed to be a self-righting system, provided you leave it alone to do its own thing.

Another definition of economics is that it’s the study of ‘the economic problem’, which is the problem of scarcity. Scarcity arises because our resources - of land, labour and capital - are finite, whereas our wants are infinite. Scarcity in this context doesn’t mean as scarce as hen’s teeth, merely that things aren’t free - they can be acquired only at a price. Economists believe the right price for something is the price that reflects the degree of scarcity (ie the cost) of the resources embodied in it. Prices are too high when they exceed the item’s scarcity value; prices are too low when they understate the item’s scarcity value.

So microeconomics is about economists seeking to help the community grapple with its abiding material problem, the problem of scarcity, which causes many of our wants go unsatisfied. Economists’ contribution is to help the community use its finite resources in ways that allow it to satisfy the optimum quantity of wants - that is, not the maximum number of wants but the combination of wants the community most highly values. In other words, microeconomics is about helping the community get a quart out of a pint pot, get more bang for its buck. This explains the microeconomists’ preoccupation with efficiency - getting the most bang for your buck - and its close relative, improved productivity. But ‘efficiency’ is a word to which economists attach their own meanings. At one level, what economists call ‘technical efficiency’ (or sometimes productive efficiency) is about being economical in the use of resources, eliminating waste, finding better ways to do things. That’s pretty much the common meaning of efficiency. But economists are more interested in what they call ‘allocative efficiency’ - which is about making sure the community’s resources are allocated to producing that combination of goods and services that it most highly values. The market could throw up lots of different combinations, but economists want to help us strive for the combination we most highly value. While we’re at it, let me just define productivity - it’s not production, its production relative to the resources used to produce it, or output per unit of input. The most common measure of productivity is the productivity of labour - output per worker, or per hour worked.

But economists aren’t engineers or management consultants or even business people. So how do they think they can contribute to making factories more efficient or improving the overall allocation of resources? They don’t profess to know much about the detail of any of these things. But they don’t think they need to because what they understand is the power of market forces, and it’s market forces that - if you stand out of the way - will bring about improvements in technical efficiency and allocative efficiency. Firms seek continually to improve their technical efficiency because of their assumed desire to maximise their profits. Consumers, in their efforts to maximise their utility (satisfaction), unconsciously seek to maximise allocative efficiency. And firms co-operate in this, giving consumers exactly what the consumers want because that’s the way firms maximise their profits.

How do consumers and firms decide what to do? By reacting to prices and changes in prices. Prices (and remember that interest rates and wages are prices) act as incentives, and yet another definition of economics is that it’s the study of incentives. If a market isn’t as efficient as it could be, the reason is likely to be that the incentives it faces have been distorted in some way, probably by misguided government intervention. So you should reform intervention in the market (deregulate), which will increase the competitive pressure on firms in the market. Increased competition will increase the pressure on firms to improve their technical efficiency - raise their productivity - but will also oblige those firms to pass the benefits of their higher productivity on to their customers in the form of improved service or lower prices. The lower and less distorted prices - prices that more accurately reflect scarcity value - will lead to greater allocative efficiency. As I’m sure you’ve realised, what I’ve been outlining is the rationale for micro-economic reform, the goal of which is simply to use improved technical and allocative efficiency and higher productivity to increase our material living standards.

Economic rationalism

Mention of microeconomic reform brings me to explaining the difference between economists and economic rationalists. Not all economists are economic rationalists and not all economic rationalists are economists. Economic rationalists are people who take a fundamentalist attitude towards the neo-classical model that’s at the heart of conventional microeconomics. They have a simple, almost religious faith in the efficacy and applicability of the model. Most government, business and media economists and many academic economists would be happy to wear the economic rationalist label, but many academic economists wouldn’t. The latter are far too conscious of instances of ‘market failure’ and other limitations of the simple neo-classical model, whereas economic rationalists tend to think problems of market failure aren’t a big deal. The non-economists who are economic rationalists - such as the former Liberal backbencher John Hyde and the chairman of the ACCC, Graeme Samuel - tend to be libertarians and great believers in individualism, who are attracted to the certainty, logicality and simplicity of the model. It offers a simple, obvious (though not necessarily easy) answer to every problem - which is the attraction of all forms of fundamentalism.

In my experience, those mainly academic economists who specialise in the study of particular markets - such as health economists and labour economists - tend to be much more conscious of the relevance of instances of market failure to that market, whereas general economists are happy to run any particular market through their pocket neo-classical model without worrying too much about the peculiarities of that market.

This may be the place for me to observe that, in my experience, labour economists (and the related discipline of industrial relations specialists) tend to be highly factionalised. Most tend to be openly sympathetic to the union cause, though you can always find a few who defend the employer interests. I regret that it’s so hard to find knowledgeable labour economists who try to call it down the middle.

The strengths of economics

Having given you a very basic explanation of what economics and economists are on about, let me move to the critique. The first thing to say is that there’s a lot of truth and power to demand-and-supply analysis. Market forces are powerful. People do change their behaviour in response to price signals. You do see people driving the long way to avoid paying a toll, driving round to find the cheapest service station, queuing and pushing and shoving to get the best bargains at the Boxing Day sales. You do see black markets emerging where governments attempt to hold prices below the market-clearing level. You do see rent control leading to an inadequate supply of rental accommodation.

One of the useful roles economists play is to remind us of the importance of opportunity cost. Because resources are finite and can be used only once, if you use them to acquire item A, you can’t use them to acquire items B to Z. The opportunity cost of an action is the cost of the next most desirable action you must give up. It’s a pathetically simple concept, but it’s surprising how often we forget it, so economists do well when they continuously remind us to be sure we really want the things we say we want because, in choosing them, we’re giving up other things.

A related benefit of the economic way of thinking is that it encourages us to continually ask the follow-up question: but then what happens? People are always coming to wrong conclusions on economic questions because they look only at direct, first-round effects, failing to trace through the second, subsequent or indirect effects. For instance, non-economists often conclude that computerisation destroys jobs in the industry in which it’s applied. They don’t go on to ask the question: but then what happens? What happens is that the productivity of the firm’s labour improves - it can now produce more output per worker, which constitutes an increase in real income. Some of that increase may be passed on to the firm’s remaining workers in higher wages, some may be passed on to customers in lower prices (or prices that are ‘lower than they otherwise would be’) and some may be retained by the firm’s owners. The point is that, wherever the income ends up, it will be spent, and when it’s spent it will create jobs. This why economist say that new technology doesn’t destroy jobs it ‘displaces’ them, moving them from the original industry to industries elsewhere in the economy.

Now, you may say, but what if the jobs lost are for middle-aged blue-collar males in manufacturing, whereas the jobs created are more suited to white-collar women working in the service industries? Good question. I think this happened a lot as computerisation worked its way through manufacturing in the 1970s and 80s. Sometimes the problems of the individual tend to be overlooked as economists focus on generalised answers. Some would say we should have done more to help these men retrain to make them suitable for other jobs, but a hard-line economic rationalist would claim that these men would have found jobs had it been possible for the price of their labour to fall to a level low enough to reflect its now reduced value, thereby making that labour attractive to some employer.

One way to test an economic argument you’re being given is to ask whether it’s approaching the issue from the demand side or the supply side. An argument isn’t fully persuasive unless it takes account of both sides. For instance, it’s not enough to say that part-time jobs have become more prevalent over the past 30 years because it’s more efficient for a firm to employ two or three workers for a few hours on Thursday nights and Saturday mornings, rather than one worker for 40 hours a week. This is undoubtedly true and it’s a good example of the kind of things employers do to keep the productivity of labour steadily increasing from year to year. But, in the context of the labour market, it’s a demand-side explanation; it focuses on what suits the buyers of labour, employers. It’s not fully convincing until you can find a story that explains the growth in part-time work from the viewpoint of the suppliers of labour, the workers. But you can find such a story, of course: it’s not hard to believe there’s been a growth in the number of married women and full-time students who’ve been happy to take up part-time rather than full-time jobs.

The role of models

Even so, the neo-classical model often oversimplifies things and leads to mistaken analysis and wrong predictions. Just like model trains or model planes, economic models consciously simplify complex reality. They’d be of no use if they didn’t. The idea is to include and highlight the key factors and get rid of the unimportant issues that merely cloud the workings, thereby capturing the essence of what causes what. The question to ask of a model is not whether it’s left things out, but whether what it’s left out is important. And the test of that is how good it is at predicting how people (‘economic agents’) will behave in given circumstances. I believe that, in many circumstances, the standard model’s prediction record is poor.

The weaknesses of the model can be seen by looking at the assumptions on which it’s built. It’s important to understand that formal economic reasoning, which is often done mathematically, is rigorously logical - given the assumptions on which it’s based. So if you don’t like the conclusions of economics, the thing to examine is the assumptions on which the reasoning is based.

The weaknesses of economics

To me, conventional economics’ greatest weakness is its assumption that agents are ‘rational’ - that is, that we always act with carefully calculated self-interest. We know from much psychological research - not to mention common observation - that people are instinctive rather than rational. They frequently make decisions contrary to the model’s predictions, they have trouble predicting their own utility, make logically inconsistent decisions, have trouble making themselves do what they know is in their longer-term best interests, are moved by altruism and perceptions of fairness and much, much more. One of the most effective criticisms of economic analysis is: I don’t believe real people behave that way. How do you, the economist, know they do? Honest answer: we don’t know it, we just assume it.

One major weakness of the model that economists readily acknowledge (but don’t necessarily take sufficiently seriously) is its inability to take account of factors than aren’t reflected in prices. Any costs or benefits that aren’t reflected in market prices are known as ‘externalities’. When I run a factory that emits pollution into the atmosphere or the river this imposes a cost (a ‘negative externality’) on the rest of the community that isn’t reflected in the actual costs I incur and pass on to customers in my prices. When, in the good old days, statutory authorities trained far more apprentices than they needed, knowing they’d be poached by the surrounding private employers, they were generating a benefit (a ‘positive externality’) those firms didn’t have to pay for and for which the statutory authorities received no recompense. The existence of externalities - positive or negative - constitutes an instance of ‘market failure’. That is, the market and its price mechanism can’t be relied on to deliver the favourable outcomes the standard model promises. The solution is to find ways to ‘internalise’ the externalities to the costs and benefits faced by firms and consumers - to get them reflected in prices - so the price mechanism can deal with them. This is done by devices such as pollution taxes, tradable permit schemes and government subsidies.

There are various other classes of market failure apart from externalities, but I tend to think of them in terms of ‘model blindness’. Economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made.

The community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness and redistributive effects of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of problems and market failure. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Problems with the simple model of the labour market

These are general problems with economists’ use and abuse of their model, but let’s cut to the chase and focus on problems with the use of the conventional model to analyse issues in one particular market, the market for labour, in which workers are the suppliers and firms the demanders. General economists have a tendency to analyse the labour market as though it’s just another market, but there’s an obvious and most important respect in which the labour market differs from other markets. In every other market you’re dealing with the buying and selling of inanimate objects, whereas in the labour market the thing being bought and sold can’t be separated from the seller - that is, whether you like it or not, the unit of labour you buy comes with a live human being attached. That human may be agreeable or disagreeable, cooperative or uncooperative, hard working or lazy, capable or incapable. The fact that labour comes with humans attached cannot fail to affect the behaviour of both the buyer and the seller, something the model makes no allowance for. The role of humans is a strong argument against analysing the labour market in a way that totally ignores considerations of fairness. Another consequence is that the cost of labour to the employer is the income of the employee (ignoring the role of labour ‘on-costs’ such as payroll tax, workers compensation premiums etc). The attachment of humans to labour also invalidates the usual assumption that the items being bought and sold are homogenous. Two carpenters with identical qualifications and experience may be quite different as employees.

The standard model of the labour market assumes that, ceteris paribus, the higher the price of something, the less of it people will buy. This is the rationale for economists’ opposition to minimum wage rates. Set the minimum wage at a level higher than the rate the market would determine - that is, set the rate at a level that’s ‘binding’ - and the result is the market doesn’t ‘clear’. Some people remain unemployed. There is truth to this simple argument, but it ignores a complication: by how much would wages have to fall to achieve the elimination of unemployment? In other words, to what extent would people already employed under a binding minimum wage have to suffer a loss of income to achieve jobs for those at present unemployed? Would a small fall in the rate bring about a large increase in demand or would it take a large fall to bring about a small increase in the quantity demanded? In the jargon, is the demand for labour relative to its price elastic (sensitive to changes) or inelastic? This is the question on which economists need to be pressed. They will come armed with empirical estimates of the price elasticity, but how much faith you should have in those estimates is another matter. They’re pretty safe to have picked estimates that suit their case and to have ignored estimates that didn’t.

The basic model of the labour market assumes that the suppliers of labour face a simple choice: supply an hour of work and earn income or choose an hour of ‘leisure’ (which just means non-work) and enjoy yourself. The bit the model gets right is that leisure yields utility (satisfaction) - though this is something business people and economists often fail to acknowledge in their rhetoric. However, what the model gets wrong is its assumption that work yields disutility - that the only reason people work is for the money, the spending of which yields utility. In real life, most of us derive considerable utility from our work; much of our very identity comes from our work. This flaw in the model prompts economists to underestimate the importance of job satisfaction, job enrichment and job security. They underestimate the personal pain of unemployment - pain greater than can be explained by the loss of income involved - partly because of the hidden assumption of their model that the unemployed are to be envied for all their leisure time. (Another reason is the neo-classical model’s assumption that the macro economy is in a permanent state of full employment, so no one stays jobless for long.)

A related problem - which should really come under the heading of model-blindness - arises from the fact that the model takes account of only those factors that can be readily expressed in monetary terms. This leads to the sloppy assumption that the only incentives that matter are monetary. In truth, the working world abounds in non-monetary incentives: the satisfaction of a job well done, loyalty to employers and a desire for the boss’s approval, not to mention the pursuit of power and status.

An implicit assumption of the model that’s highly relevant to Work Choices, but which many economists conveniently forget, is that the parties to a transaction have roughly equal bargaining power. Where the parties’ bargaining power is highly unequal you won’t necessarily get the mutually beneficial outcomes the model promises. Certainly, the gains aren’t likely to be evenly distributed. This is the economic rationale for economists’ long-standing acceptance of the legitimacy of collective bargaining. The fact that so many economic rationalists are supportive of the push for individual contracts makes me suspect their analysis has been clouded by partisanship.

Work Choices has made me increasingly conscious of another of the model’s weaknesses: its neglect of what you might call ‘social externalities’. I’m disturbed by the attack on - the demonisation of - penalty rates for work at unsociable hours and the scope for partially cashing out holiday pay. My worry is not so much that the compensation for the loss of these benefits may be inadequate, but that these penalties performed an important social function. Combined with the deregulation of shopping hours, the attack on penalty rates is bringing about the steady demise of the weekend. Why is this a good idea? Although all of us like being free to shop or visit places of entertainment on the weekend, the trend to working at unsociable hours must be harmful to family life - something of great utility to all of us.

There’s no denying that, if increasing productivity and our material standard of living were our sole objective, keeping our shops, offices and factories operating for as close to 24/7 as possible would help us achieve it. But who in their right mind would have such an unbalanced approach to life? Workaholic businessmen and economists blinded by their model to the importance of social externalities.

Labour market reform

I have no doubt that our move from the centralised wage-fixing system to bargaining at the enterprise level - the end of flow-ons and one-size-fits-all national wage increases and the downplaying of comparative wage justice - has played a major part in the economy’s improved performance: the return to low inflation, the record-length 16-year expansion phase that has allowed so much progress to be made in reducing unemployment and the fact that our biggest commodities boom in 50 years has so far led to no wage breakout.

But I think this has more to do with the decentralisation of wage-fixing than the deregulation of it. It’s far too soon for Work Choices to have played a significant part in these outcomes - with the possible exception of the remarkably low wage increases being recorded in retail and hospitality. The productivity of labour grew extraordinarily strongly in the second half of the 90s and this helps explain the quite strong growth in real wages during the Howard Government’s term, notwithstanding the maintenance of low inflation.

When it suits them, the economic rationalists like to attribute all the credit for our improved productivity performance to the reform of the labour market. They can’t prove this, of course, and at other times they’re inclined to give the credit to all the other reform we’ve seen in the financial system and the markets for particular products: the floating of the dollar, the deregulation of the banks and countless other industries, privatisation, the virtual ending of protection, the reform of monopoly public utilities, tax reform and so forth.

My guess is that more of the credit should go to product market reform. The intensity of competitive pressure - both domestically and from imports - in so many markets has reduced the market power of firms, ended the sweetheart deal and put a lot of pressure on managers to improve the performance of their firms. They, in turn, have passed the pressure on to their workers, exhibiting a toughness, even callousness that wasn’t there to nearly the same extent in the good old days. Having said that, the move to enterprise bargaining has undoubtedly made it easier for managers to drive a harder bargain with their employees.

Conclusion

Economists specialise in studying the material aspect of our lives and how we can improve it. They are knowledgeable and their advice is effective. As we have proved for ourselves over the past 20 years, following that advice will make the community more prosperous. But while the material aspect of our lives is important, it’s not all important. Sensible people seek to balance affluence against other considerations - fairness and the social, artistic and spiritual dimensions of our lives. The trouble with economists is that their advice is narrow - sometimes narrower than they’re aware of and often more narrow than their hearers realise. Sensible communities don’t allow economists to advise on areas outside their field of competence and balance the advice of economists against the advice of experts in the other important aspects of life.

Tuesday, September 18, 2007

The fundamental objective of microeconomic reform is to improve the economy’s technical, allocative and dynamic efficiency and thereby raise our material standard of living. In distinction to conventional macro management – which focuses on stabilising demand over the short term – microeconomic policy focuses on improving the supply (production) side of the economy over the medium to longer term.

The mechanism for micro reform

The basic mechanism of microeconomic reform is to reduce government intervention in product and factor markets (the capital or financial market and the labour market) in ways designed to increase the degree of competition in those markets. Increased competition in markets should increase the pressure on firms both to raise their technical efficiency and to pass the fruits of that higher productivity on to their customers in the form of better service or lower prices. Combined with prices that better reflect the true ‘resource costs’ of producing goods and services, this should improve the efficiency of the allocation of resources within the economy, thereby causing a higher trend rate of economic growth and thus higher material living standards.

Dynamic efficiency

Dynamic efficiency refers to the economy’s ability to adjust over time in response to changing circumstances. A dynamic economy is adaptable, responsive and flexible. It is able to cope with external or domestic economic shocks to supply or demand without generating either too much inflation or too much unemployment. Our economy’s ability to sail through the Asian crisis of 1997-98 – assisted greatly by the dollar’s depreciation when demand for our exports fell off – convinced many economists that micro reform had made our economy a lot more flexible than it had been.

And, as part of this, our lasting return to low inflation has shown the economy to be much less ‘inflation-prone’ than it had been. Intensified competition in so many markets has greatly reduced the scope for firms to exercise pricing power, for importers to pass on imported inflation and for unions to negotiate excessive, ‘sweetheart’ wage deals. In short, we now have much less problem with ‘cost-push’ inflation. Another part of this is that the move to enterprise bargaining and away from centralised wage fixing has greatly reduced the scope for big pay rises in one area to ‘flow on’ to workers in other areas. This would have helped to lower our NAIRU – the ‘non-accelerating-inflation’ rate of unemployment - thereby permitting the unemployment rate to go lower without igniting wage-inflation problems.

The economy’s greater dynamism and ability ‘roll with the punches’, this has made it less unstable and thus made the macro managers’ job of stabilising the economy as it moves through the business cycle a lot easier – a major, but largely unexpected benefit from micro reform.

Key microeconomic reforms

We can list eight key areas of micro reform over the past two decades:

1. Capital markets. The Australian dollar was floated in December 1983 and controls over foreign exchange removed. Bank interest rates were deregulated and foreign banks licensed to operate in Australia.

2. Trade reforms. Import quotas – mainly for motor vehicles and textiles, clothing at footwear – were removed in the late 1980s and tariff protection for manufacturing and agriculture phased down. The effective rate of assistance to manufacturing fell from around 35 per cent in the early 1970s to 5 per cent by 2000.

3. Infrastructure services. Airlines, coastal shipping, telecommunications and the waterfront were partially deregulated. Government utilities – including railways, ports, electricity and water – were made more efficient and less overstaffed. Many were commercialised and corporatised; some were privatised. Government-owned banks, insurance companies, airlines and a telephone company were privatised.

4. Industry deregulation. Many industries – including stock broking, petrol distribution, eggs, bread and dairy – have been deregulated, as have shopping hours.

5. Government services. Many reforms have been introduced, including competitive tendering and contracting out, performance-based funding, the formal definition and costing of ‘community service obligations’ and user-pays pricing.

6. Labour market. The prices and incomes Accord, operating from 1983 to 1996, restructured and simplified awards and shifted from centralised wage fixing to enterprise bargaining. The Howard Government’s Workplace Relations Act of 1996 further reduced the scope of awards and introduced a formal system of individual employment contracts known as Australian Workplace Agreements. Work Choices seeks to discourage collective bargaining and unionism.

7. Taxation reform. Capital gains tax, fringe benefits tax and the dividend imputation system were introduced in 1985 and 1987, along with large cuts in income tax rates. The goods and services tax was introduced in 2000, replacing the narrow wholesale sales tax and a range of state stamp duties. The company tax rate was cut to 30 per cent.

8. National competition policy. An agreement between Paul Keating and the state premiers in 1995 had four main elements: extension of the Trade Practices Act to government businesses and the professions; reforms to public monopolies; introduction of a regime to provide other firms with access on reasonable terms to privately owned monopoly infrastructure services; and introduction of a program to review all federal and state legislation restricting competition. National competition policy has now been replaced by the National Reform Agenda.

Evidence of the benefits of micro reform

During the five years to 1998-99, labour productivity grew at the highest rate for at least 30 years. The improvement in the average productivity growth rate over this five-year period (of about 1 percentage point) provided the equivalent of an additional $7000 to the average Australian household.

This remarkably strong performance is widely attributed to the delayed effects of micro reform. In the years since then, however, our productivity performance has fallen back to normal levels. This may be because of the fall-off in further reform under the Howard Government. The poorer performance in very recent years is thought to be due partly to the surge in mining investment associated with the resources boom which, while the new production capacity is still coming on line, means the mines are employing more workers without any increase in output. This should be just a temporary factor, of course.

Thursday, September 13, 2007

I want to start by saying that, in a minor way, The Sydney Morning Herald is an employer of economics graduates from Sydney University. We hire about one every two years. Over the years we’ve hired Steve Burrell, Stephen Ellis (now a columnist from America in the Business Australian), Tom Allard, Jessica Irvine and Jake Saulwick. We’ll have another one coming on board next year. (I wish I’d hired another name you may recognise, Stephen Long of the ABC.)

The thing to note is that everyone on that list is a product of Political Economy, not the mainstream economics course. So I have pretty well-formed views about Sydney University graduates as potential employees. Why do I hire out of PE? I like PE students because PE is an essay-based course (and economic journalists have to be able to explain economics in words, not diagrams or equations), because PE students have a demonstrated interest in politics (and I regard economic journalism as a branch of political journalism) and because PE seems to attract a disproportionate share of very bright students (and I try to hire only people who are exceptionally bright).

In passing I should tell you that I don’t select trainees on the basis of the marks they got. I’m more interested in their extra-curricular activities - whether they were on the SRC, got involved in running clubs and societies, whether they wrote for Honi or the Union Record - because what I’m really looking for is people with a burning desire to be a journalist, people who’ll throw themselves into it, people who are ‘hungry’ to succeed.

I should tell you that I’m very happy with the people I recruit from PE, which is why I keep going back. In recent years, however, I’ve encountered one problem: most PE graduates haven’t actually done any courses in standard, neoclassical economics. It’s amazing, but true. This is a significant weakness and I usually have to insist that the people I hire go back and do some standard economics by distance education. I don’t think the people running PE are doing their students any favours churning out supposed economists who know less about conventional economics than someone who’d done economics at high school.

What I say to my PE graduates is that I don’t require them to believe the neoclassical model - as we’ll see, I have a lot of doubts about it myself - but I do require them to know it inside out. Why? Because the neoclassical model is the language of the public debate about economics in this country and every other country. If you don’t speak the language, you don’t participate or even understand the argument. You’re certainly in no position to convince the participants in the debate they’re barking up the wrong tree.

Of course, some of the conventional economics graduates who are whizzes at the maths aren’t good at speaking the language, either. But while I’m offering a critique of PE, let me be equally frank about the conventional course. I think its great weakness is the opposite of PE’s - it’s so busy teaching the intricacies of the neoclassical model that it doesn’t find time to give students an adequate understanding of the significant limitations of the model and the alternatives to it. To teach the model without adequately explaining its limitations is, to me, professional negligence. So there’s nothing wrong with economics at Sydney Uni that couldn’t be fixed by rolling the rival courses together - by making sure each side gets a fair dose of what the other side is teaching.

I also suspect the conventional course would be better if it devoted less time to exploring the model’s limiting cases and more to giving students practice at applying the model to specific problems. That is, after all, what economic practitioners do: apply the theory they learnt at uni to the real-world policy problems they are grappling with. But don’t get the idea from this I’m critical of the emphasis on theory in university economics courses. I’m not - not a bit. Universities should be all about theory. Theory is their comparative advantage. It’s the only thing they’re good at and they should stick to it. They shouldn’t worry about teaching vocational skills because it’s hard to learn vocational skills at uni and surprisingly easy to learn them on the job - when you get a job. It’s because economic practitioners spend their professional lives applying the theory they learnt at uni - because pretty much all the theory they know is the theory they learnt at uni - that unis should concentrate on giving their students the best understanding of theory possible. And students should concentrate on tanking up with theory while they’ve got the chance and not worry that it’s all too theoretical. The practice will come later. And when you’ve had a bit of practice you’ll realise that the theory was more useful than you thought when you were learning it.

That’s probably the most useful thing I could say to many of you: don’t sit around telling yourself how useless and unrealistic all the theory is they’re trying to make you learn. You haven’t actually had enough experience to have an informed view of what theory’s useful and what isn’t. So take your lecturers on trust: accept that if they think it’s worth teaching it must be worth learning. If my experience is any guide, when you are experienced enough to judge you’ll realise most of what they taught you was worth learning.

Of course, decent teaching of theory gives plenty of attention to teaching the limitations of the theory. So now that I turn to my topic of what’s wrong with standard theory please don’t think I’m saying economics is rubbish and you’re wasting your time with it. I’m not saying that and I don’t believe that. I could give you a speech on what’s right and useful about the neoclassical model - and if I had time I would - but instead I want to talk about the limitations of the model because that’s where I suspect the conventional course is weakest. Everything in life has strengths and weaknesses and neoclassical economics is no exception.

Perhaps before I launch in I should explain that my view of my role as an economic commentator has changed over the years. For a long time I saw myself as a sort of missionary for economics, explaining the economic way of thinking and trying to persuade people to accept the economic rationalists’ policy prescription. But that was before I’d thought more and read more about the limitations of standard economics. So now I see my role as someone paid to provide the Herald’s readers with a critique of economics and economists, just as theatre critics provide our readers with a critique of the latest plays. Economists are so influential in the debate about public policy - and they act so certain that they’re the bearers of God’s Infallible Truth - that our readers often need reminding of their blind spots and the narrowness of their advice. Of course, putting economists back in their box when I consider they’ve overstepped their area of competence doesn’t stop me still devoting a lot of time to explaining economic concepts and the motivation behind government policy positions.

I suspect the biggest problem with economics is that it split off from the rest of science - the natural sciences and the social sciences - over 100 years ago, so that while there have been many major advances in those sciences since then, economics has been in its own, self-contained world and has carried on down its own path oblivious to those advances.

In Eric Beinhocker’s recent book, The Origin of Wealth, he argues that, thanks to the work of Leon Walras and others in the 19th century, the primary inspiration for neoclassical economics was physics, particularly the physics of motion and energy. Walras introduced differential calculus to economics and the organising paradigm that the economy is an equilibrating system. But Beinhocker says economics took its inspiration from physics at a time when physicists had discovered the first law of thermodynamics, but not yet discovered the second law. As a result, economics is based on terribly out-of-date physics. It’s now clear to physicists - but not economists - that the economy isn’t a closed, equilibrating system at all, but rather an open, disequilibrium, complex adaptive system.

To quote Beinhocker, ‘when Walras imported the concept of equilibrium from physics into economics, he gained mathematical precision and scientific predictability. But he paid a high price for that gain - realism. The mathematics of equilibrium required Walras and later economists to make a set of highly restrictive assumptions that have increasingly detached theoretical economics from the real world. Traditional economics has what computer programmers call a “garbage in, garbage out” problem. If you feed a computer bad inputs, it will with absolute precision and flawless logic grind out bad outputs. Likewise, most traditional economic models begin with unrealistic assumptions and then, with mathematical inevitability, work their way to equally unrealistic conclusions. … This is why there is little empirical support for many core ideas of traditional economics, and in some cases empirical evidence directly contradicts the theory’s predictions.’

The point here is not that conventional economics is too mathematical, but that it’s not using the right maths. The right maths would, no doubt, be a lot trickier and permit a lot less precise conclusions. But I don’t want to be drawn any further on this point because, though I’ve been happy to quote Beinhocker, I don’t profess to know anything much about physics and maths.

I’m a lot more confident in pointing to another area of science where, more than 100 years ago, economics split off on its own track, so that it’s now largely oblivious to subsequent advances. That science is psychology. It was quite primitive 100 years ago, but since then has made considerable gains in understanding the drivers of human behaviour. It’s quite understandable that, with psychology being then as primitive as it was, economics built itself on the assumption that economic agents behaved rationally in all things. It was very much a product of the thinking of the Enlightenment.

But psychology’s challenge to microeconomic theory strikes at that central assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People are not rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ (packaged) differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore sunk costs as he’s supposed to and often can’t order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances.

Another aspect of the non-rationality of economic agents is the way, contrary to the assumptions of the model, they aren’t rugged individualists but are heavily influenced by the behaviour of people around them. My tastes and preferences aren’t fixed, but are highly variable, influenced by what others are doing and what happens to be fashionable. I care deeply about winning the approval of others and have a great desire to fit in. At the same time I’m preoccupied with my social status. I want by my conspicuous consumption to not just keep up with the Jones but to overtake them, demonstrating my superior social standing. As my real income rises over time, more and more of it will be devoted to the purchase of positional goods. This is a particular challenge to conventional economics because, while it’s very skilled at raising the material living standards of the community generally, it’s simply powerless to do what most people would wish it to: raise their relative income. Obviously, anything it does to raise the relative income of some people will lower the relative income of just as many. Another aspect of the fact that humans are group animals is the herd behaviour investors so frequently exhibit in markets for financial assets, contrary to the contentions of the efficient market hypothesis.

Thanks to relatively recent advances in neuroscience, we now know a lot more about how our lack of rationality is a function of the way our brains have evolved. It turns out that the primitive, more instinctive, emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be silly.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport or studied harder for exams - are prospective and uncertain. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, gambling or even speeding, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Problems of self-control are ubiquitous to modern life, but standard economics is oblivious to their existence.

Before we pass on I should acknowledge that the relatively recent school of economic thought known as behavioural economics is fully aware of the way the assumptions of standard economics fly in the face of advances in psychology and is seeking ways for more realistic assumptions about human behaviour to be incorporated into the equations of the standard model. I suspect, however, it won’t be easy.

Moving to a more mundane level, economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made. It occurs partly because there is so little engagement between economists and people from other disciplines - so that economists rarely get a chance to see themselves as others see them - and partly because the teachers of economics devote so little attention to ensuring their students fully appreciate the limitations of the model.

As we’ve seen, the community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains. It’s been remarkable to see the Howard Government running advertisements to remind small businesses of the changes to the Trade Practices Act that now permit them to bargain collectively with big business, while at the same time using Work Choices to discourage collective bargaining between individual workers and their employers.

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Yet another major weakness of the model is its failure to take account of social externalities. The deregulation of shopping hours, combined with the attack on weekend penalty rates, is fast bringing about the demise of the weekend without the community ever consciously deciding this would be a good thing. Similarly, I believe Work Choices’ attack on overtime, weekend and public holiday penalty rates and provisions for the partial cashing out of holiday pay could be damaging to family life.

Then there’s the sloppy thinking that goes from the fact that economics is capable of dealing only with monetary incentives to the implicit assumption that only monetary incentives matter. This is classic model-blindness. Clearly, the real world abounds in important non-monetary incentives, including the intrinsic enjoyment of work and pursuit of job satisfaction, and the pursuit of power and status. Ignore these factors and you get wrong answers.

But perhaps the thing that worries me most about standard economics is the way its adoption of the assumption of ‘revealed preference’ - that what people do is a reliable guide to what they want - in the 1930s allowed the goal of economic efficiency to be changed from maximising utility to maximising consumption. Clearly, much utility exists outside consumption - including utility derived from job satisfaction, job security and family life. I fear this derailing of the goals of economics has turned economics into the ideology of materialism and economists into the high priests in the temple of mammon.

This at last brings me to my ostensible reason for being here, to publicise my new book, Gittinomics. What is Gittinomics - what’s my special twist on the subject? Well, most of what I’ve said today isn’t in the book. The book is a kind of exposition of how the micro economy works, but from the perspective of the ordinary person. I call it home economics. My emphasis is on understanding the system to make sure you’re a master of the market system, not a victim. Making it work for you, not you for it. To that end, the first thing to understand is the need to keep economics in perspective and economists in their place.